Carbon Tax vs. Cap and Trade: A Nuanced Argument

There have risen two prominent approaches to addressing the adverse effects of carbon dioxide and other pollutants. One is to simply tax carbon emissions — hence the term carbon tax. The other approach is to set a limit on the total emissions that can be emitted, and to distribute or auction off emissions permits to emissions-producing companies. This approach is known as emissions trading, or cap-and-trade. Which is the better approach? Daniel Walker and Seth Taylor-Brill debate to find the answer.

Carbon Tax

When California enacted its cap-and-trade program in 2013, it was expected that many other states would follow suit. However, not a single state has, and cap-and-trade remains a controversial scheme. However, I believe that cap-and-trade is the best way to reduce emissions, and is much more efficient than a flat carbon tax.

First, it is necessary to define what these two programs do: A carbon tax is fairly straightforward; it is simply a fixed fee per ton of carbon dioxide produced. A cap-and-trade program is a little more complicated. To put it simply, the government sets a ceiling on the amount of carbon dioxide that can be produced each year. Then, it either doles out or sells at auction a certain number of permits to produce carbon dioxide, with the sum of those permits totaling the government-set ceiling. Then, the companies that have received these permits trade them amongst each other, allowing each company to gather however many permits it needs to meet its CO2 production that year.

This means that while a carbon tax sets a definite price on carbon, it does not set a definite cap on the amount of carbon produced. If the government were to set the tax too low, the tax would not be able to lower CO2 emissions as much as was hoped. Cap-and-trade has the opposite effect. The government, by setting a ceiling on the amount of CO2 that year, knows exactly how many greenhouse gases will be produced. Then, it lets the companies set their tax for themselves as they trade CO2 permits amongst each other. The average cost of a CO2 permit will be the true cost of reducing CO2 emissions to the target level for the industry. There is no danger of the tax being too low or high.

"There is no danger of the tax being too low or high."

However, beyond these on-the-surface benefits of a cap-and-trade system, the design encourages innovation to reduce emissions even further. Imagine that there is a flat tax of $100 per ton of carbon dioxide produced, and that Firm A produces 10 tons of carbon dioxide a year. If Firm A would have to spend more than $100 per ton of carbon dioxide produced to reduce emissions, then they would just pay the tax and be done with it. However, in a cap-and-trade program, a company can profit by reducing emissions. Suppose that Firm A is allotted 10 one-ton CO2 production permits, which each sell for $100 on the open market. Now Firm A has an incentive to pay to reduce its emissions, as it can now sell its CO2 production permit for $100 every year after it has reduced its emissions. This effect is magnified when firms have different costs to reduce emissions. A newer plant with lower costs to reduce emissions can sell its CO2 permits to an older plant, costing the older plant less than it would have to pay to modernize its facilities and making the newer plant money in the process. Emissions are reduced all the same and the firms pay less to comply with standards, making the system a win for everyone.

As companies employ new technologies that drive down the cost of complying with the CO2 ceiling, it will become easier to reduce emissions the longer a cap is in place. By contrast, there is no incentive to innovate under a flat carbon tax, and therefore no reason that reducing carbon emissions would ever become cheaper or easier in the future.

Cap-and-trade’s more efficient permit system and incentive to innovate make it much more effective as a policy tool to reduce overall emissions, and it is my hope that it is more widely used in the future.

You might want to address the objection that the government cannot be immediately certain of the ideal number of permits to distribute or auction off and, if distributing, the methodology of distribution. Just as a carbon tax may be too high or low, the number of permits distributed or auctioned off may be too high or low. What seems like an ideal number of permits may not be.

Cap and Trade

Anyone who has taken high school economics knows that pollution creates a negative externality that the market cannot take into account on its own. This is because firms generally care only about their own costs, not those which they impose upon society. Therefore, government intervention is required to reach a socially optimal price and quantity of pollution. Of course, this assumes that climate change is a dangerous, human-driven occurrence. As there is overwhelming evidence in support of this assertion, I will instead focus on the best form of government intervention. There are two primary ways to reduce carbon emissions: a carbon tax and cap-and-trade. I will argue for the former.

The two above solutions approach the problem of pollution in different ways but have similar effects. The carbon tax aims to correct the price of polluting and to allow the market to determine quantity of pollution, whereas the cap-and-trade method aims to control the quantity of pollution and to allow the market to determine the price of polluting. In theory, it seems preferable to control the quantity of pollution since the threat of global warming is far more dangerous than any economic misstep. However, the cap-and-trade method runs into a problem that the carbon tax avoids – namely, administration. It is difficult to administer the allocation of allowances [1]. Even if it were somehow possible to determine a fair allocation of allowances to the nearly 320 million Americans and their various unique geographic and economic realities, enforcing those allowances would be prohibitively expensive. This complication would make it nearly impossible to impose cap-and-trade regulations on normal American’s gas consumption. In the case of industrial pollution from factories and plants, the only politically palatable option is to auction allowances (which has, admittedly, been done with some success by the Regional Greenhouse Gas Initiative (RGGI) in many Northeastern states of the U.S.). But even the RGGI recognized that allowances had been oversupplied, most likely as a result of political pressure and lobbying to do so [2]. The cap-and-trade model is based on the Coase theorem, which essentially argues that markets with little to no transaction costs will reach a socially optimal equilibrium, regardless of the initial allocation of entitlements [3]. Let’s break this down.

"[F]rom an economic perspective, the initial allocation of allowances might not matter; from a political perspective, it is necessary that the initial allocation is deemed fair, which is why the auction system is so important."

First, even from an economic perspective, the initial allocation of allowances might not matter; from a political perspective, it is necessary that the initial allocation is deemed fair, which is why the auction system is so important. Additionally, even if the allowances are allocated correctly, that does not mean that the total number of allowances is optimal (I will discuss this more later on). Next, let’s analyze the assumption that the Coase theorem makes: few transaction costs. When two firms trade allowances, they waste money on brokerage, legal, and consulting fees. Sometimes (especially for smaller firms), these transaction costs can be prohibitively expensive and prevent the market from reaching a socially optimal equilibrium. The viability of cap-and-trade depends on whether transaction costs are low and whether the initial allocation of allowances can be done in a politically/economically favorable way. The carbon tax lacks these dependences and thus is more reliable.

Proponents of the cap-and-trade model would argue that the carbon tax is less effective at reaching the socially optimal quantity of pollution because policy makers do not have perfect information on potential market responses to a given tax. They argue that the amount of trial and error required to determine the perfect level of taxation would damage the market. While this is true, the cap-and-trade model runs into a similar problem. When choosing the amount of allowances to auction off, the government cannot be certain of the effects on the industry. If the government were to auction off too few allowances, it would run some firms out of business and make products prohibitively expensive to consumers. Alternatively — and more likely — political pressure from interest groups would likely lead to an excess of allowances and a failure to reduce pollution. Therefore, a lack of information is not just a problem with the carbon tax.

Finally, let’s consider the major advantage of the carbon tax: it provides government revenue in a way that does not create deadweight loss (in fact, it eliminates deadweight loss). Nearly all other forms of taxation create some form of deadweight loss. This is because taxes result in a higher cost of production or purchase price in the market. This, in turn, leads to a lower level of production than would otherwise ideally exist. The carbon tax is different in that a lower level of production is exactly what we want. The revenue from the carbon tax would allow the government to reduce the levels of inferior forms of taxation. This advantage represents the most significant difference between the two models.

Between the carbon tax and a cap-and-trade system, the carbon tax is superior because it generates revenue efficiently and avoids the problems with transaction costs and administration of allowances that cap-and-trade encounters.